What Is Currency Risk?
Currency risk, commonly referred to as exchange-rate risk, arises from the change in the price of one currency about another. Investors or companies with assets or business operations across national borders are exposed to currency risk that may create unpredictable profits and losses. Many institutional investors, such as hedge funds and mutual funds, and multinational corporations, use forex, futures, options contracts, or other derivatives to hedge the risk.
What is operating exposure?
Operating exposure to foreign exchange risk impacts exchange rate changes on a company’s future operating revenues and costs.
To the extent that a firm’s competitive position is affected by changes in exchange rates, it has operating exposure, even if it does not deal with foreign currencies.
Thus a ski resort in Chile, with no FX transactions, has operating exposure to FX risk if a devaluation of the Argentine peso draws customers to cheaper destinations in the neighboring country.
What is transaction exposure?
Transaction exposure measures the effect of exchange rate on foreign currency denominated transactions—sales and purchases for which a contract is in place.
For example, an exporter with EUR as its functional currency has an agreement to sell finished goods to a US client in three months.
The export, denominated in USD, is settled another three months after the goods are delivered.
The period between the sale is initiated and settled creates currency risk for the EUR cash flow as the EUR-USD rate fluctuates.
When the corresponding foreign currency denominated accounts receivable/payable are issued and appear on the firm’s balance sheet, the transaction also creates accounting exposure.
What is translation exposure?
Exposure to currency risk is the effect of exchange rate changes in the current balance sheet and income statement.
Translation exposure comprises the foreign currency gains and losses that occur when a group’s financial statements are consolidated, and the accounts of foreign subsidiaries are translated into the home currency.
FX translation can be carried out by expressing all balance sheet and income statement items at the current exchange rate or by applying different exchange rates (current rate/historical rate) to other assets and liabilities on the balance sheet.